Lifetime Net Tax Rates

One of the few good things Dick Darman ever did while serving as George Bush's Director of the Office of Management and Budget was to initiate a section in the budget dealing with generational accounting. Beginning with the 1993 budget, issued in January 1992, calculations were made on what the lifetime net tax rate would be for Americans born in different years. The net tax rate is defined as total taxes paid over one's lifetime less government transfers received as a percentage of total labor income, all in present value terms (i.e., adjusted for the rate of interest).

The technique was developed by Professors Alan Auerbach of the University of California, Jagadeesh Gokhale of the Federal Reserve Bank of Cleveland, and Laurence Kotlikoff of Boston University. The idea is to look at how Federal fiscal policies affect different generations. They show that the older one is the lower their lifetime net tax burden. This is because tax rates tended to be much lower during the working lives of current retirees, while Social Security benefits are very high relative to their contributions.

It should be remembered that the original Social Security tax rate was just 1 percent in 1937 (on both employer and employee) on the first $3,000 of earnings, and benefits began being paid out as early as 1940. Obviously, everyone retiring in the early years of the program received a huge windfall, having paid in virtually nothing. As time has gone by, of course, Social Security tax rates have risen sharply to the current rate of 7.65 percent on the first $61,200. As a result, each succeeding generation is paying more into the system and getting back relatively less.

The generational accounts essentially work out this relationship and quantify it. As the figure indicates, for someone born in the early part of the century the combination of lower tax rates during their working lives and more generous retirement benefits gave them a lifetime net tax rate in 20 to 25 percent range. For those born since World War II, they will pay 30 to 35 percent. However, for future generations as yet unborn, they can expect to pay lifetime net tax rates of more than twice that level unless current policies are changed.

According to the latest calculations, recently published by the Federal Reserve Bank of Cleveland, Clinton's policies have had the effect of raising the lifetime tax rate for every age group. Shockingly, the lifetime tax rate on future generations has risen from 71 percent to over 84 percent. Thus it is not surprising that the Clinton Administration dropped the generational accounts from its 1996 budget.